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What Hedge Funds Can Teach College Students

By

Matt Wirz

November 12, 2011

Ask hedge fund manager Daniel Ades about the future for recent college graduates and he likes to draw a picture, a very ugly picture. He sketches out a bell curve mapping the historical default rate on student loans.

Then he draws another curve much higher to show the likely default rate for the Class of 2011.

Ask hedge fund manager Daniel Ades about the future for recent college graduates and he likes to draw a picture, a very ugly picture. WSJ's Dennis Berman discusses the topic with Mean Street host Evan Newmark. AP Photo.

Mr. Ades has become an expert in the $242 billion market for bonds backed by bundles of student loans, delivering consistently strong returns by trading hundreds of millions of dollars worth of the debt over the past four years. "We know all these deals inside out and we know their default rates," he said.

Some students are growing more skeptical of the investment return of an undergraduate college education, discouraged as they see recent graduates struggle to find jobs and increasingly default on their loans. Melissa Korn has details on Lunch Break.

But when it comes to the loans that banks made to students who graduated in 2010 and 2011, the 31-year-old investor is steering well clear, "because we can't quantify the risk," he said.

Robert Pizzo

About Generation Jobless

Americans 25 and under face one of the toughest job markets in modern history. This week, The Wall Street Journal explores their stories.

From College Major to Career

Investors like Mr. Ades have a unique view on the future for America's job-seekers. Their investments depend on accurately predicting young people's ability to repay their loans, which means they obsess about everything from employment rates by profession to the long-term earning potential of young graduates.

Historically, investors have assumed 25% to 30% of student loans bundled into their bonds will default. But today they are baking in between 30% and 40% default rates among the current crop of graduates, said Chris Haid, a director in asset backed trading at Barclays Capital. Even those assumptions are a best guess and defaults could ultimately go higher if unemployment rises, Mr. Haid said.

This analysis translates into some surprising insights for students and policy makers. For example, in the current economy, it may make more sense to enter a technical college than to go to law school.

Not all lessons from the bond market are so counterintuitive. The most important, in fact, is a slight twist on a maxim most students know from childhood: stay in school, just not too long.

Failure to graduate is the single most important predictor of whether a student will default on loans, which stands to reason since the unemployment rate is 8% for Americans between the ages of 20 and 24 with four-year college degrees, compared to 21% for those without.

Just as important is finishing on time. Investors in bonds backed by student loans hate to see perpetual academics in their portfolio, chronically changing majors or stopping and starting school, adding years of tuition to their debt load.

"When you see a guy in a loan made in 2005 that is still in school, you throw that away," said investor Rubin Bahar, of Eagle Asset Management.

In terms of picking a school, technical colleges may be less prestigious, but their low cost relative to the higher wages they deliver makes them attractive, according to Mr. Ades.

Tuition at public two-year colleges in the U.S. will cost $2,963 a year on average in the 2011 academic year, compared to $28,500 a year for four-year private colleges, according to estimates by non-profit group The College Board.

"It's not just about where you can get the best education," he said during an interview in the Miami Beach office of his hedge fund, Kawa Capital Management. Students should pick schools where the payoff from higher salaries upon graduation exceeds the cost of the education by the widest margin, he contends, especially when the job market contracts.

By that arithmetic, technical colleges come out on top, Mr. Ades said. "We're in a skills based economy and what we need is more computer programmers, more [nurses]," he said. "It's less glamorous but it's what we need."

Law school, on the other hand, can end up a sucker's bet in periods of high unemployment, experts in student loan-backed bonds say.

While college students often enroll in professional programs to wait out economic soft patches, the U.S. has far more law schools than other professional schools, resulting in an excess supply of lawyers, argue investors and analysts.

In recessions, law school graduates have a harder time finding work than other graduates from professional programs and are more likely to default on their student loans.

Nevertheless, law students have been willing to take on even more debt for their degrees, borrowing a record $68,827 on average to attend public universities this year and $106,249 for private educations, according to the American Bar Association.

Given the state of the economy, Milwaukee, Wis.-based Stark Investments is staying away from all student loan bonds right now. It is instead focusing on mortgage-backed debt with comparable yields and less risk, said portfolio manager Anup Agarwal. "We don't expect unemployment rates to go down for the next year or two so it's difficult to get excited about student loans against that backdrop."

Uncertainty about student defaults has essentially frozen the market for bonds backed by student loans that aren't guaranteed by the government. The volume of such bonds secured by loans made by
SLM Corp.
, also known as Sallie Mae, is at just 16% of the level in 2009, according to rating firm DBRS Inc.

In many cases Sallie Mae is refusing to lend to students unless they can get parents to co-sign on the loans. Almost 70% of students who took out private loans with Sallie Mae since 2008 were forced to have a parent co-sign, compared to just half the students who borrowed with the lender from 2002 to 2007.

What this boils down to for prospective students is that banks are lending less, and charging higher interest rates for the loans they do make. Colleges, on the other hand, aren't charging any less. With less debt available to them, students will be forced to ask whether paying top dollar really pays off, Mr. Ades said.

"It shouldn't cost this amount of money for higher education," he said. "Class size of 10 is not necessary for students to learn."